Just One Little Problem...

Black-Scholes underpinned massive economic growth. By 2007, the international financial system was trading derivatives valued at one quadrillion dollars per year. This is 10 times the total worth, adjusted for inflation, of all products made by the world's manufacturing industries over the last century. The downside was the invention of ever-more complex financial instruments whose value and risk were increasingly opaque. So companies hired mathematically talented analysts to develop similar formulas, telling them how much those new instruments were worth and how risky they were. Then, disastrously, they forgot to ask how reliable the answers would be if market conditions changed.

Black and Scholes invented their equation in 1973; Robert Merton supplied extra justification soon after. It applies to the simplest and oldest derivatives: options. There are two main kinds. A put option gives its buyer the right to sell a commodity at a specified time for an agreed price. A call option is similar, but it confers the right to buy instead of sell. The equation provides a systematic way to calculate the value of an option before it matures. Then the option can be sold at any time. The equation was so effective that it won Merton and Scholes the 1997 Nobel prize in economics. (Black had died by then, so he was ineligible.)
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The Black-Scholes equation relates the recommended price of the option to four other quantities. Three can be measured directly: time, the price of the asset upon which the option is secured and the risk-free interest rate. This is the theoretical interest that could be earned by an investment with zero risk, such as government bonds. The fourth quantity is the volatility of the asset. This is a measure of how erratically its market value changes. The equation assumes that the asset's volatility remains the same for the lifetime of the option, which need not be correct.

It's a genius act of advanced mathematics, which gives us predictability in an area of uncertainty and allows us to trade options at the level of ten times the total value of a century's production. There turns out to be just one little problem with it.

Despite its supposed expertise, the financial sector performs no better than random guesswork.

Oops. Guess that's why all those folks who used to have good jobs in construction are now raising their kids on the EITC. It wasn't because they didn't realize how dumb they were; it's because somebody else thought he was too smart.

This seems like a problem for our model too, though. We just finished a long talk about how markets make better decisions -- at least, when immediate information is available locally. Now, the financial sector is nothing if not a market. Isn't that right?

8 comments:

People will gamble, and if they lose, they won't have assets available to create jobs by hiring other people. Do you see this as a failure of the market? The market means people put their own money where they decide it will work out best for them. If they make bad decisions, they lose money, so gradually resources quit getting allocated in that direction. Overall, this means resources get allocated in directions that work out well. But by definition, this means lots of transactions won't be profitable or assure any security or jobs. The people who looked forward to well-paying jobs with the losing gamblers will have to go find jobs with winners instead.

If we had a system available that could avoid the bad transactions and put money only into good ones, it would be very tempting to give up the freedom of the free market in that new system's favor. But there is no such system. The people who would like to be put in charge of running it probably think they have a foolproof system, but no one's ever had one. All they have is hindsight.

You can enforce fraud laws against people who take investors' money and use it in gambling schemes that they've lied about, but you can't remove the gamble from investment altogether, or at least not if you want overall growth or prosperity.

I guess what I'm wondering about is this: William F. Buckley said he'd rather be governed by "the first 400 people listed in the Boston telephone directory" than by the faculty of Harvard, i.e., by an essentially random sample rather than by experts.

That seems like the problem we're looking at here too. If we made predictions by random guesswork, we would at least understand that it was a gamble and structure our bets accordingly. But because we have the expertise, we're backing 'the wisdom of the market' to a degree that is manifestly unwise (10 times a century's production).

If it proves (as it does) that the market isn't wiser than random guesswork, that doesn't mean we need new experts. The existence of claims to expertise is the problem.

What it may mean is that we need not to allow bets beyond a certain scale.

But "we're" not placing bets. Individual people with money are placing bets with their own money, or are giving their money to other people to do so. Should those people not place crazy bets? Probably not. As long as we don't bail them out when they lose, that's their problem.

If casinos in Vegas let people gamble with credit cards and no limit, they'd find that some people lost a trillion dollars and then weren't good for it. So they don't let people run up that big a tab, or if they do, they don't get the Fed to print money to pay for it.

Indeed, you're quite right: they don't let people run up that big a tab. That's kind of what I'm after here. We need a way of defining the scale.

In the analogue, who would be the one who 'did not let them run up that big a tab,' and what would be the enforcement mechanism? How do we institute that very sensible reform -- casinos are extraordinarily rational actors -- in the wider financial system?

Keep the government out of it, and whatever entity is extending the credit will either cut off an unreliable borrower on its own initiative, or else go broke when the borrower can't pay. Again, it's not something "we" do, it's something the entity that's a financial risk does for itself -- unless it knows that the taxpayers will bail it out. Casinos deal with a lot of risk, but although they sometimes go broke, how often do you see the taxpayers bail them out? Imagine how big a mess you could make if the word got out that the taxpayers could be relied on to do that? How hard would the casino look at the credit check for the high roller?

Another way we get into trouble via government intervention is in writing regulations that encourage or even require federally-insured institutions like banks to buy the securities that the government decides are "safe." That's a pretty benign requirement if the only things we call "safe" are T-bills -- at least until we degrade the currency by printing too much money. We can also get away with including triple-A securities, if we don't engage in too much willful self-deception about what the rating agencies are doing. But if all those financial institutions that loaded up on sovereign currency investments and MBSs had really been making their own bets with their own money, they'd have thought twice about whether some piece of junk that no one really understood was truly a AAA risk. That goes double if no one had assumed that a quasi-government-backed entity like Fannie Mae was there to buy up all the MBSs that could be inked without any regard for whether they genuinely were worth anything any more, or at that volume. And if some idiot financial institution did buy up too many of them, it eventually would go bust and be replaced by a more prudent one. One of our problems is that the prudent banks can't compete against the imprudent ones as long as the taxpayers are there to bail out the imprudent ones.

A belief in a taxpayer bailout is a foolproof recipe for a bubble and a pop.

I think the key is that a free market, will make the best decisions. Barring government interference, collusion, price fixing, monopolistic behavior, and ... oh, human nature in general. Like pretty much every other theoretical means of doing everything, we humans have a bad habit of mucking it up. Yes, we WOULD be best served if everyone pulled their own weight and contributed to the greater good. But that is simply never going to happen. Some joker will always be willing to cruse along and let everyone else carry his weight, and then others will see him do it, and do likewise, and so on. A bit cynical you say? Perhaps, but I'll stand by it.

"Now, the financial sector is nothing if not a market. Isn't that right?"

Maybe. Maybe not. One thinks of a market as the place where one trades stored labor (in the form of money) for product, and sells product for money. The financial sector, at least large parts of it, aren't really doing that anymore, they're more a sort of 'casino' where one bets on the likelihood of the future value (or loss of) something on the market, but isn't really trading the product itself. I understand the value of having this device, as it raises capital for companies so that they may grow beyond what they would be able to do in the conventional market, but are those parts of the financial sector really a market? I think it's a very good and difficult to answer question.

We just finished a long talk about how markets make better decisions -- at least, when immediate information is available locally.

Ah, but there's a difference between "data" and "information". And there's also a difference between "information" and "bullshit". The problem comes in when someone with a PhD tells people something is the former when it's actually the latter, and they believe him or her.